Micro-Mechanics - DBS Research 2022-10-31: Near-Term Weakness To Persist

• Refer to Micro Mechanics's earnings announcement dated 28 Oct 2022:

1QFY23 revenue saw slowing growth, below expectations.

• Micro-Mechanics (SGX:5DD)’s 1QFY23 (three months ending Sept 2022) revenue came in at S$20.2m (-8% q-o-q, -1% y-o-y), which came in below our expectations. 1QFY23 sales in China, which is Micro-Mechanics’s largest market, came in at S$5.5m (-13% q-o-q, -24% y-o-y). Lower sales in China were due to lower orders placed by Chinese customers, attributed to their stockpiling of Micro-Mechanics’s products back in 1Q22 when the industry was experiencing supply chain disruptions.
• Separately, Micro-Mechanics’s US subsidiary (MMUS), which caters to Micro-Mechanics’s second largest market, also saw revenue growth moderating q-o-q, with its 1QFY23 revenue at S$4.9mil (-13% q-o-q, +21% y-o-y).
• In 1QFY23, the Singapore and Philippine markets saw positive revenue growth q-o-q at +4% and +31%, respectively, although both markets made smaller revenue contributions, aggregating at 21%, versus China/US contributing 27%/24% to revenue, respectively.
• Overall, 1QFY23 saw moderating growth of -8% q-o-q and -1% y-o-y, highlighting slowing conditions in the global semiconductor industry. Although, 1QFY23 capacity utilisation rates remained stable and healthy at 61% (4QFY22: 60%, 1QFY22: 61%).

Margins continue to see pressure, the worst is potentially not over.

• Micro-Mechanics’s 1QFY23 gross margins declined to 51.0% (4QFY22: 51.6%, FY22: 53.4%) on the back of continued inflationary pressures (e.g., operating expenses such as fuel and manpower costs) and supply chain challenges (e.g,, aluminium and steel for MMUS).
• Although 1QFY23’s margins of 51.0% were above management’s target of 50.0%, the margins witnessed in 1QFY23 were the lowest margins seen since 3Q19 (2019 was a downturn year for the semicon industry due to the US-China trade tensions).
• As a result of lower gross margins, Micro-Mechanics's 1QFY23 net profit came in at S$4.2m with a net profit margin of 21.0% (4Q22: 26.7%, FY22: 24.0%).
• We are cautious towards future margin outlook, due to ongoing headwinds including staff shortages, inflationary pressures (e.g., fuel, material costs), further supply chain disruptions, and other operating challenges, which will likely pose continued downward pressures on margins.

US subsidiary saw continued operating losses in 1QFY23.

• MMUS continued to see operating losses in 1QFY23 (FY22 operating losses of S$0.06m, FY21: operating profit of S$1.2m). Losses in the US subsidiary are partially due to lower-than-expected sales growth and ongoing raw material and manpower challenges. We believe it is key to watch for MMUS’s financials, as it is among the group’s largest markets.

Turning more cautious due to the cooling semiconductor industry outlook.

• According to World Semiconductor Trade Statistics (WSTS), worldwide chip sales in Aug 2022 showed a decrease of 3.4% m-o-m compared to Jul 2022, which was its third consecutive month of contraction. Additionally, the Semiconductor Industry Association (SIA) said that global semiconductor sales growth has slowed substantially in recent months, with y-o-y sales increases in Jul and Aug dropping to single-digit growth for the first time since Dec 2020. The sharpest decline in chip sales was witnessed in the China market, which is one of Micro-Mechanics’s key markets.
• Going forward, Gartner estimates semiconductor revenue to decline by 3.6% in 2023, due to ongoing macro headwinds and weakening consumer demand. We expect worldwide semiconductor shipments to dip further in the coming months (see report: Singapore Technology Stocks - DBS Research 2022-10-18: Semiconductor Outlook Turning Negative Near Term). We note a strong positive correlation of ~+0.90 between global chip sales and Micro-Mechanics's share price; the cooling semiconductor outlook could act as a negative catalyst to Micro-Mechanics's share price.

Longer term outlook remains intact.

• Based on historical data, the upcycle (positive y-o-y gain) lasted about two to three years, followed by about one year of weakness (negative y-o-y growth). We expect a similar trend this time round.
• Going forward, we believe the longer term outlook remains healthy and is supported by the structural shift in demand post pandemic.

Healthy balance sheet and cash balances.

• Micro-Mechanics remains in a sound financial position. As at 30 Sept 2022, Micro-Mechanics’s balance sheet had total assets of S$75.9m, shareholders’ equity of S$62.3m, cash and cash equivalents of S$25.3m, and no bank borrowings. In our view, Micro-Mechanics’s healthy balance sheets may potentially help the group tide through periods of industry slowdown.
• Further, we believe Micro-Mechanics’s healthy cash balances can help support its dividend payouts; we assume a constant FY23F/24F dividend of S$0.14, following that of FY22A and FY21A, which translates to a FY23F/24F dividend payout ratio of 121%/100% (versus FY21A/22A of 108%/98%). See Micro Mechanics's dividend history.

Revised FY23F/24F earnings downwards by 22%/14%.

• We have revised our FY23F revenue growth forecast for Micro-Mechanics by -3.6%. Additionally, we have also assumed lower gross margins for FY23F at 50.5% (1QFY23: 51.0%) and lower net profit margins for FY23F at 20.3% (1QFY23: 21.0%), on the back of further inflationary pressures. As a result, we have revised our FY23F/24F earnings forecast for Micro-Mechanics downwards by 22%/14%, respectively.

Downgrade Micro-Mechanics to FULLY VALUED with revised target price of S$2.32.

• Our target price is pegged to ~20.0x FY23F P/E, aligned with Micro-Mechanics’s average historical four-year forward P/E ratio. We anticipate macro headwinds and a slowing semiconductor outlook to catalyse a downward rerating of Micro-Mechanics's Share Price towards its average forward P/E ratio.